Monday, September 29, 2008

As a believer in market solutions/mechanisms, the last few weeks have been trying, to say the least." How, in the face of all that has happened, can you still trust markets?" is a question that I have been asked. I could give you all the facile answers - it is not the market's fault... imperfect regulatory frameworks are to blame... errant traders are the reason.. but my heart is not in any of these explanations.

I think that markets did fail, at least partially, in this cycle, just as they have in other cycles in the past. The costs are being borne by all of us. Notwithstanding the failure (and others like it), here is why I still remain a believer in markets. Markets exaggerate the best and worst aspects of human nature. At their best, human beings are creative, innovative and capable of bouncing back from the worst of adversity, and markets allow them to have maximum impact. From the Model-T Ford to the Google search engine, financial markets have allowed entrepreneurs to reach beyond their local markets, reach a broader marketplace and change the world in the process. At their worst, human beings are short term, greedy and not particularly rational, and markets feed into these emotions. When markets are good, we exalt them and when they are bad, we detest them.

So, here is the question. Would we be better off without financial markets? The good of markets, in my view, vastly outweighs the bad. While that may seem debatable at this point in time, consider two of the fastest growing economies in the world - India and China. For centuries, the people in the two most populous countries in the world stagnated under controlled economies (with colonial powers, royalty and central governments - socialist or communist- all promising a better future, but not delivering). In two decades, markets have done more to bring the the poor out of poverty in these countries than the rulers from prior generations. I may be an optimist but I do trust markets more than experts, when it comes to the big issues of the day!

Let's get the bad stuff out of the way first. It was an awful day for investors in every market. There was no safe haven today. I am sure that you are convinced that the end of the world is coming but let me offer you my take on the market.

First, the bad news. The credit crisis is spreading beyond mortgage backed securities. As banking failures in Europe illustrate, the problem is a much wider one. Banks lost their perspective on default risk and lent money at rates that were far too low to borrowers who did not meet the creditworthy test - individuals, corporations and businesses. As borrowers default, loan portfolios are being savaged around the world and the banks that were most aggressive about seeking out growth are facing the consequences. Banks spread their pain around and there is no way that the global economy will not feel the pinch. At this stage, the question seems to be no longer whether we are in a recession but how deep and long the recession lasts. The failure of the bailout bill also illustrates the precarious state that markets are in: we are really in trouble when traders on the floor are watching congressional vote tallies and reacting to the success and failure of legislation.

Second, the neutral news. So what do I think will happen next? There will be congressional action, though I am not sure whether the action will be necessarily in the long term best interests of either Wall Street or Main Street. The market will have its relief rally, just to show that it is playing along.

So, what is the good news? Investors, consumers and economies are a lot more resilient than we give them credit for. While the great depression seems to increasingly be a theme in business news stories, I think that the modern global economy can weather the storm and come out of it intact. My suggestion to you is to think long term (if you can afford to) and invest in companies with healthy balance sheets and solid products. The Coca Colas, Apples and Nestles of the world will still provide long term value.

Sunday, September 28, 2008

The blame is being spread around for the current crisis: securitization, lax regulation and the housing bubble have all been fingered as culprits, but I think that these were contributing factors. I would attribute what has happened on financial markets to two phenomena, one of which is age-old and cannot be easily cured by regulation or laws and the other of which can be remedied.

1. Over optimism and hubris: Through history, we (as human beings) have always exhibited these traits. In good times, we become complacent and under estimate the likelihood of their ending, and we also tend, when successful, to attribute that success to our skills (rather than to luck or good fortune). It does not surprise me that there was a housing bubble and I do not believe for a moment that this is the last bubble that we will see in our lifetimes. There will be other bubbles in other markets, just as there always have been through history.

2. Risk taking and risk bearing: I know that risk is viewed as a bad word now. Rather than viewing excessive risk taking as the problem, we need to examine why it occurred in the first place. I believe that the separation between risk taking and risk bearing is at the heart of this crisis. Our risk takers (traders, bankers, mortgage brokers) sought out risks because they shared in the lucrative upside (with compensation tied to profits from activity), but the downside of risk was borne by others (the deposit insurers, taxpayers, other banks and investors). To fix this asymmetry we need to do two things:

(a) Reform compensation systems to make them less tied to outcomes in short periods. A trader who receives a large bonus in the year in which he makes a large profit on his trading position is receiving encouragement to take the wrong types of risk. Compensation should not only be tied to more long term results but should also be linked to process (as opposed to outcome). In other words, a trader who makes money by taking the wrong types of risk should be punished and not rewarded.

(b) Price risk correctly: A system that systematically subsidizes excessive risk taking by charging the same price for insuring all risk takers, no matter how much risk they take, is a system designed to fail in the long term. Charging all banks the same price for federal deposit insurance, while allowing them to have very different loan/asset risks, will result in some banks gaming the system for profit. Prudent banks and taxpayers should not be providing subsidies for imprudent risk taking.

I am not suggesting that either of these actions will be easy to implement, but the task is laid out for us. It is time to get to work!

Friday, September 26, 2008

This is the first of three posts that I hope to put up on my thoughts on what we see unfolding in financial markets. Here is my take on what happened:

1. The ultimate sources of this turmoil are the real estate market and the bond market. Between 2002 and 2007, housing prices increased at rates unseen in decades and well above the inflation rate. At the same time, default spreads on bond markets converged on historical lows.

2. As housing prices increased, funded by cheap mortgage financing, the mortgages themselves were bundled into mortgage backed securities, entitling buyers to different layers of the collective cash flows on the mortgages, with the first layers having the least risk and the last layers of the cash flows having the most risk.

3. The same optimism that pervaded the housing market (about future housing prices) and the bond market (about future default spreads) led to the mispricing of every layer of these mortgate backed securities, with the mispricing being greatest at the riskiest (or top) layers of the cashflows.

4. Financial services companies (banks, investment banks, insurance companies) were the primary investors in these mortgage backed securities, with the former using debt to fund much of their holdings. In some cases, investment banks were buying the riskiest layers of the mortgage backed debt, using short term financing.

Here is how it unraveled:

1. Housing prices started their decline at the end of 2006 and accelerated into 2007. The contemporaneous economic slow-down also started pushing up default spreads in bond markets.

2. The values of the mortgage backed securities on the books of buyers started dropping as the built in assumptions about increasing housing prices and low default risk came under assault.

3. A few financial service companies reacted quickly and sold some or most of their holdings by mid-2007, taking their losses. Most held on, hoping for a market turn-around.

4. Accounting requirements on marking-to-market required banks to begin restating the values of their securities to reflect current value. As the values of mortgage backed securities dropped, the liquidity in these markets also dried up, leading to big write-offs in value, which in turn reduced the book equity at these firms.

5. As the book capital dropped, these firms started showing up on regulatory warning screens as being under capitalized, based on book equity. (In late 2007, firms like Lehman and Bear Stearns could have made equity issues or raised fresh equity to provide a safety margin, but they believed they could ride out the storm).

6. As the liquidity problems in the mortgage backed security market worsened, the write downs continued. By the beginning of the summer of 2008, firms like Bear Stearns and Lehman had lost any buffer they might have had, and the equity options available at the end of the prior year had also dried up.

7. Bear Stearns is liquidated, with the Fed's help. If Lehman had one last chance to raise fresh equity, it would have been in the weeks after the Bear liquidation.

8. The hits keep coming and Lehman falls. The question, given the absence of liquidity in the mortgage securities market, is who's next? That turns out to be AIG, but it is quite clear that there will be always someone else next in line who will be targeted to fall.

9. The recognition that this is as much a liquidity problem as a valuation problem comes to the Treasury and the Fed. The Paulson bailout is a liquidity plan, where the illiquid securities will be taken off the books of financial service firms, and held by the Federal Government, the only institution that can create its own liquidity (nice to control those printing presses).

I am hoping that the next phase is a happier one but we are watching financial history get written as we speak!

Thursday, September 25, 2008

In news that was overshadowed by the bailout debate, GE announced today that it was suspending its stock buyback program. While the suspension was precipitated by declining earnings and worries about GE Capital, there are some general comments that I want to make about the action that relate to stock buybacks in general

1. Flexibility: One of the biggest reasons for the shift among US companies from dividends to buybacks was that firms can respond much more quickly to adverse circumstances with the latter. GE's announcement on buybacks was greeted with sanguinity by markets today. If GE had cut dividends, the market reaction would have been much more negative than it was this announcement.

2. Announcement versus Action: Investor should take stock buyback programs announced by companies with a pinch of salt. Many company announce buyback programs with fanfare but do not carry through all the way.

3. Valuation: Last year, companies in the S&P 500 returned twice as much cash to stockholders in the form of stock buybacks than dividends, resulting in a total yield of 5.34% on the index (about 1.9% from dividends and the rest from buybacks). One measure of whether the equity market will be able to sustain the body blows it is receiving now will be in how well the buyback number holds up for the next year or so. A bunch of companies, including Microsoft ($40 billion), have announced buyback programs.

The news of the week has been the proposed Federal (or Paulson) Bailout, with $700 billion being the price tag associated with it. Let me state at the outset that there is a crisis looming over many financial service firms and drastic action is unavoidable. So, is this bailout the solution?

1. The price tag on the bailout is a little misleading. The $700 billion is what the government will pay to buy mortgage backed securities off banks, but the net cost will be lower. In fact, if everyone goes back to paying their mortgages on time, the Federal Government will make money on the deal. It is very unlikely that this optimistic scenario will unfold. What is far more likely is that there will be defaults, and how much this bailout will cost us will depend upon how quickly housing recovers.

2. There are two keys to making this not a "bailout". The first is to pay fair value (See below) for these mortgage backed securities, rather than an optimistic value or face value. This fair value may still be a bargain for banks that face the problems of having to mark these securities to market every period. To the extent that liquidity has dried up in this market, these securities may well have to written down below fair value. The second is for taxpayers to get something in return for taking these problem securities off the books. I would use the Buffett model (from his Goldman acquisition) and ask for warrants or equity to compensate for at least a portion of the difference between the fair value and the current value (which will reflect the illiquidity).

(What is fair value? It is the present value of the cumulative cashflows on these mortgage backed securities, discounted back at a rate that realistically reflects default risk. This will be well below face value, since these securities were misvalued using default risk estimates that we too low.)

3. I know that the zeal for punitive measures is strong and that people want to punish the bankers who have put us in this position. While I will not defend sloppy valuations and poor oversight, I also believe that there is plenty of blame to go around. In fact, anyone who bought a house in the last 5 years and traded up, using a cheap mortgage to fund the move, participated in the benefits of the boom. I am not eager to seek out these homeowners and punish them either.

4. Regulation is not the answer. After all, this problem was created by a patchwork of regulations that left loopholes to be exploited. What we need is a consistent regulatory environment that covers all types of risky assets, rather than different regulatory environments for real estate, mortgage backed securities, corporate bonds and equities. In fact, I think trying to regulate trading and restrict risk taking in a global marketplace is akin to trying to stop unauthorized downloads of movies on the internet... A waste of time and money!

I think that the bailout will not end the troubles at banks, but it is a solution to the liquidity crisis that is haunting this market.

Monday, September 22, 2008

The big news of the morning is that Goldman Sachs and Morgan Stanley will reorganize themselves as bank holding companies, thus ending a decades-long experiment with stand-alone public investment banking. Before we buy into the hyperbole that this represents the end of of investment banking as we know it, it behooves to us to look both back in time and into the future and examine the implications.

Independent investment banks have been in existence for a long time, but for much of their existence, they were private partnerships that made the bulk of their profits from transactions and as advisors. They seldom put their own capital at risk, largely because they had so little to begin with and it was their own money (partners). Part of the impetus in their going public was the need to raise more capital, which in turn, freed them to indulge in more capital-intensive businesses including proprietary trading. That model worked well for much of the last two decades, but three things (in my view) destroyed it. The first was that it became easier to access low cost, short term debt (especially in the last few years) to fund the capital bets that these firms were making, whether in mortgage backed securities or in other investments. The second was that the compensation structure at investment banks encouraged bad risk-taking, since it rewarded risk-takers for upside gains (extraordinary bonuses tied to trading profits) and punished them inadequately for the downside (at worst, you lost your job but you were not required to disgorge bonuses in prior years... in many cases, finding another trading job on the Street or at a hedge fund was not difficult to do even for the most egregious violators). The third was a patchwork of government regulation that was often exploited by investors to make risky bets and to pass the risk on elsewhere, while pocketing the returns. The combination worked in deadly fashion these last two years to devastate the capital bases at these institutions. Lehman, Bear Stearns and Merrill have fallen...

So, what will change now that Goldman and Morgan Stanley have chosen the bank route? The plus is that it opens more sources of long term capital since they can now attract deposits from investors. Having never done this before, they start off at a disadvantage. The minus is that they will now be covered by banking regulation, where the equity capital they be required to have will be based upon the risk of their investments. This will effectively mean that they will need more equity capital, if they want to keep taking high risk investments, or that they will have to bring down the risk exposure on their investments. My guess is that they would have gone down one of these roads anyway. In pragmatic terms, it will also mean that their returns on equity at investment banks will drop to banking levels - more in the low teens than in the low twenties. I think the stock prices for both investment banks already reflects this expectation.

Ultimately, Goldman and Morgan Stanley have sent a signal to the market that they are willing to accept a more restrictive risk taking system. In today's market, that may be the best signal to send. There will be times in the future, where I am sure that they will regret the restrictions that come with this signal, but they had no choice.

In investing mythology, there is a special place reserved for the contrarian investor, i.e., the investor who goes against the crowd and makes money in the process. In fact, many investors, asked to describe themselves, describe their investment style as both contrarian and long term. But are you really a contrarian investor? Last Wednesday offered a simple test. At 3.45 pm, the S&P 500 was down to about 1150, the Dow had dropped 800 points in three days and the bottom was falling out of the market. If you were watching the screen at that time, which of the following impulses did you feel?

1. Denial: This is a bad dream... I am going to wake up from it any moment... It is not happening.

2. Panic: Sell everything. The world is coming to an end.

3. Cool Assessment: Buy now. Panic yields the best opportunities.

4. Wait and see: I think I should buy, but I am too nervous. Let me wait for things to settle down a little bit.

If you were truly a contrarian, you would have chosen (3) and done something about it: tapped out your cash reserved and invested in banking stocks, for instance..... For most of us, though, denial, panic and waiting would have been more natural impulses. At the risk of revealing more about my psyche than I should be, I did not pass the contrarian test. I chose to wait and see, which in the long terms turns out to be waiting and waiting for the right moment, which either never comes or comes too late. I think, though, that there are broader lessons to be learned from this test.

a. It is easy in the abstract to be a rational, long-term investor. It is much more difficult in practice. The same can be said about being a contrarian.

b. The fact that information is so much more easily accessible and timely has actually made the task of being a long-term investor more difficult. Twenty years ago, most of us would have been working in blissful ignorance at our regular jobs, completely unaware (at least during the day) that Wall Street was collapsing... and that may have been healthier.

c. You cannot force yourself to adopt an investment style that does not fit your make-up as a human being. Many of us are not hard-wired to be patient, long term investors, and fewer still have the stomach to go against the crowd.

Saturday, September 20, 2008

The risk free rate is the building block on which we erect risk premiums. When I was taking my first finance classes a long, long time ago, I was taught that the risk free rate for U.S. dollar based returns was the treasury rate - the T.Bill rate for short term and the T.Bond rate for long term. The implicit assumption, not often stated, was that the US Treasury was incapable of default. At worst, they would print more currency to pay off bonds coming due. This is a lesson I have passed on to students in my classes and put into print in my books.

This week, that conventional wisdom was challenged for the first time. After the Federal Government stepped in to provide a backstop to AIG, and then later in the week, for an even larger package of mortgage backed securities, there was a sense in markets that the rules of the game had changed. In the Credit Default Swap (CDS) market, where investor buy and sell insurance against default risk, the price for insuring against default risk in the treasury climbed to 0.25%, on an annual basis, on September 18, 2008. While it is possible that this was an over reaction to the tumult of the week, that number should give us pause. If true, the true long term riskfree rate in U.S. dollars on September 18 was not the 10-year treasury bond rate of 3.77% but the default risk adjusted rate of 3.52% (3.77% - 0.25%).

I will wait and see what the next few weeks bring. It may be time to rewrite finance textbooks to reflect the new realities.

If there is one number that captures what the market mood is right now and how investors feel about equities collectively, it is the equity risk premium (ERP), i.e. the additional return that investor are charging for buying equities instead of putting their money into treasuries. The equity risk premium reflects the tug-of-war between hope and fear that equity investors bring to the market, and will vary on a day-to-day basis. As investors become more risk averse, they will a higher equity risk premium, which should translate into lower stock prices.

Last week provided a laboratory to observe movements in both direction in the equity risk premium. We started Monday morning (9/15/2008) with the S&P 500 at 1250 and the equity risk premium at 4.54%, but here is what happened over the week:

Friday, September 19, 2008

One of the big news items competing for attention today was the SEC's decision to bar short selling temporarily on more than 700 financial service companies. While the SEC statement paid the usual lip service to the importance of allowing short selling in orderly markets, it also concluded that short selling was contributing to market instability and should not be allowed for the moment.

Implicit in the ban, and in the support that it is getting from many investors and portfolio managers, is the assumption that short sellers are bad people - speculators, naysayers and vultures who make money off long term investors. I think that short sellers, like long buyers (why not?), cannot be easily categorized. Some are motivated by good information, some are trading on rumor and some can be unscrupulous (floating false news stories to bolster their positions). While the ban may have helped markets today, here is why I think it is counter productive:

1. If we want market prices to reflect all news, good as well as bad, we have to allow people to trade on both types of news.

2. Investors who believe that the prices of Citi, Chase or Goldman are going to drop in the next few weeks can evade the ban by using options or other alternatives. In effect, banning short selling is either going to push it deeper underground or make the carnage worse on the financial service companies where other alternatives exist.

I do believe that investors who take positions in stock - long or short - should be held accountable when they try to manipulate the price afterwards. That is an enforcement issue that the SEC should be thinking about rather than short circuiting the process.

I think we have a candidate for the most exciting flat week ever. The S&P 500 started the week at 1250 and ended the week at 1255, with two huge up days (yesterday and today) offsetting two huge down days (Monday and Wednesdays). The financial world at the end of the week looked very different from the beginning, with the ranks of investment banks thinning and government suddenly becoming the biggest player in the game. I am not willing to make a prediction of whether next week will be up or down (I know - that is quite cowardly of me) but I am willing to bet it will be volatile. Hang on for a wild ride!

Wednesday, September 17, 2008

I have always believed that the Chinese symbol for risk, which combines the symbols for danger and opportunity, is the best definition of risk. Danger and opportunity are connected at the hip, something worth remembering in both good times and bad. In good times, opportunities abound, and the salespeople for these opportunities (brokers, hedge funds) tell us that there is little or no danger: those 70% returns are touted as "low-risk". In scary times, all we see is danger and no investment looks good. In both cases, we would be well served stepping back and looking for the link. Lucrative opportunities always expose us to risk, even in the best of times. And dangerous times bring opportunities, if we keep our eyes open and our wits about us!

This has been a horrendous week for markets. As markets collapse globally, and doomsday scenarios are envisioned, it is time to take a step back and assess where we are.

1. Equity indices are down about 8-9% for the week in the United States and more in some emerging markets. The S&P 500 is down almost 20% for the year, a bad year by most standards but not quite a catastrophe (yet).

2. The damage to equities has been uneven. The most pain has been inflicted in financial service companies (banks and investment banks). The decline in the rest of the market is far more muted.

3. While fear and panic are in the air in financial markets, the real economy, other than housing, has held up fairly well so far.

I do not know what tomorrow will bring, but if you have bragged about being a "contrarian", now is the time to put your money where your mouth is....

I must confess that I have mixed feelings about blogs. I do read quite a few on a variety of topics, but I have held back on starting one of my own for two reasons - first, I am not sure that I have enough to say that is interesting on a continuous basis and second, everything I say will be online for better or worse. Anyway, now that I have made the leap, here is what I hope to put on this blog on a regular basis.

1. I will try to put down my thoughts and reactions to the news of the day, with an emphasis on how the news fits into my big picture view of corporate finance and valuation.

2. I will t follow some central themes in finance - equity risk premiums, the measurement of risk - and provide regular updates on interesting research in the area and how my thinking is evolving on the topic.

3. Once in a while, I will highlight a company that I am valuing and ask for your thoughts on the valuation.